We're About to Enter a Bear Market - and It's Going to Be Painful

The next bear market could be particularly severe, largely because stock-market timers are increasingly viewing market pullbacks as buying opportunities. This behavior, characterized by increased enthusiasm for stocks even during downturns, indicates a level of exuberance that’s often seen as bearish from a contrarian perspective.

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This optimism among market timers stems from a pattern over the past year where market pullbacks have been shallow, encouraging a buy-the-dip mentality. As a result, the so-called "Wall of Worry" — a market condition where skepticism fuels cautious, yet persistent gains — has weakened. Rebuilding this Wall, or shifting market timers’ perspective so that they don’t treat every decline as a buying chance, may require a significant and painful market drop.

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This rising optimism can be observed in the Hulbert Stock Newsletter Sentiment Index (HSNSI), which tracks the average recommended equity exposure among several dozen short-term stock-market timers. Notably, the HSNSI’s lows have become progressively higher. A year ago, for instance, the HSNSI dropped to minus 15% during a market pullback.

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However, in recent months, even amid market downturns, the lowest levels of the HSNSI have been notably higher. During a July-August decline, it only dropped to 12%, while September’s low was 32%, and in the most recent dip, it reached no lower than 52%.

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A historical example that illustrates the danger of this pattern is the dot-com bubble’s peak in early 2000. During this period of extreme optimism, the stock market had enjoyed a remarkable run-up in the late 1990s, where every pullback was considered a prime opportunity to buy. So, when the market finally peaked in March 2000, most market timers assumed this was just another temporary dip, leading them to increase their stock exposure even further.

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In fact, when the market had already dropped by 10% from its peak, the average recommended equity exposure among market timers focused on the Nasdaq was even higher than it had been at the market’s top. This was a classic case of irrational exuberance.

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While this analysis doesn’t pinpoint exactly when the market will reach a peak, it does suggest that risk levels are unusually high. This year has presented challenges for contrarian analysis, as optimism among market timers has frequently persisted in what’s typically seen as a “danger zone” for excessive optimism. The HSNSI has been in this optimistic range for 63% of the year, which would normally signal caution, yet the stock market has managed to perform strongly.

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Despite the market’s resilience this year, history tells us that it won’t rise indefinitely. Contrarian indicators imply that a market peak could be imminent, and when it does occur, the ensuing downturn may be especially sharp and painful.

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Beyond stock-market timers, sentiment analysis extends to other asset classes. In addition to the HSNSI, there are sentiment indexes for Nasdaq-focused stock-market timers, gold timers, and U.S. bond-market timers. The current levels of all these indexes, relative to their historical ranges, offer further insight into broader market sentiment across different asset classes.

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Together, these sentiment measures suggest that heightened enthusiasm is not confined to equities, indicating a widespread, potentially overconfident market environment that may soon be tested by a substantial correction.

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